Return on invested capital (ROIC) – Michael Mauboussin on investment concepts

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Calculating return on invested capital - Michael Mauboussin

The one dollar test

Businesses must pass the one dollar test. That is, they must earn a return of invested capital (ROIC) in excess of the opportunity cost of capital. In their paper, Calculating Returns on Invested Capital, Michael Mauboussin and Dan Callahan provide a helpful introduction to the topic. We highly recommend that you read their paper in full if you have the time. If not, this post will provide a crude summary of it. This includes a look at return on invested capital as a measure of performance and the nuances to keep in mind when working with such metrics.

Return on invested capital

Return on invested capital (ROIC) is a measure of capital efficiency and the company’s overall performance. We can calculate it by dividing a company’s net operating profit after tax (NOPAT) by its invested capital (IC). Unlike return on equity, high financial leverage does not distort ROIC.

ROIC = NOPAT / IC

Net operating profit after tax (NOPAT)

Net operating profit after tax (NOPAT) measures the company’s cash earnings before financing costs. Technically, NOPAT is earnings before interest, taxes and amortisation (EBITA), minus associated cash taxes. Additionally, cash taxes should consider tax provisions, deferred taxes and any tax shields. The effective tax rate for growing industries is generally more modest due to increases in deferred taxes. We can also subtract investments (i.e. change in net working capital, net CAPEX and net M&A) from NOPAT to derive free cash flows (FCF) for discounted cash flow (DCF) analysis.

NOPAT = EBITA * (1 – Cash Tax Rate)

FCF = NOPAT – Investment Needs

Invested capital (IC)

Invested capital (IC) is the level of assets that a business needs to operate. We can intepret it as the level of financing from creditors and shareholders that the company requires to support operations. There are two approaches to estimating invested capital:

  1. Assets approach: IC = Net Working Capital + Net Property Plant & Equipment + Goodwill + Other Operating Assets
  2. Liabilities and equity approach: IC = Total Debt + Total Equity + Deferred taxes + Other long-term liabilities

Net working capital (NWC)

Net working capital (NWC) is the cash level that a company needs over the following twelve months. Working capital changes are sensitive to company growth rates.

NWC = Current Assets – Non-interest Bearing Current Liabilities

One measure of strength

ROIC is one measure of company strength and performance. Mauboussin suggests that companies that earn a consistently high ROIC are likely to exhibit some competitive advantage and/or management strength. Professor Bruce Greenwald also dicusses this at length in his book, Value Investing: From Graham to Buffett and Beyond. Greenwald suggests that companies without a durable competitive advantage will see incumbents or new entrants drive their ROIC down.

Similarly, it is for these reasons that investors likes to search for companies that earn consistently high returns on invested capital. In The Little Book That Beats the Market, Joel Greenblatt describes his ‘magic formula’ of screening for companies that earn high ROIC, while trading at high earning yields. He believes this is a simultaneous filter for quality and value, which has seen some empirical success.

Returns on incremental invested capital (ROIIC)

Returns on incremental invested capital (ROIIC) focuses on the relationship between incremental earnings and incremental investments. It compares the change in NOPAT in a given year to the change in invested capital made in the year before. Mauboussin suggests that high ROIIC is an indicator of capital efficiency or high operating leverage, and can help to inform potential moves in earnings. It is useful to calculate both ROIC and ROIIC to provide an absolute and relative measure of spending effectiveness.

ROIIC = (NOPAT_t2 – NOPAT_t1) / (IC_t1 – IC_t0)

Mauboussin notes that a company that achieves an ROIC equal to its cost of capital should have a P/E ratio that is inverse to the cost of equity. Mauboussin and Callahan observe that firm ROICs tends to revert to its industry average over time. While the firm’s P/E ratio is also likely to revert over time, it is the underlying ROIC that drives this multiple.

Again, some companies may sustain a high ROIC and ROIIC if it enjoys an enduring competitive advantage. In his book Competition Demystified, professor Greenwald suggets investors consider the degree and durability of demand advantages (e.g. switching costs), cost advantages (e.g. technology) and/or economies of scale that the company might currently enjoy. Similarly, in The Little Book That Builds Wealth, author Pat Dorsey recommends investors consider the strength of intangible assets, switching costs and network effects as well.

Return on invested capital nuances

Mauboussin and Callahan also outline several factors that may affect our interpretation of ROIC. This includes excess cash, good will, restructures, operating leases, research & development, minority interests and share buybacks.

Excess cash

Arguably, companies are responsible for all use of capital and should therefore earn a return on all capital on its balance sheet, including cash and marketable securities. However, since ROIC focuses on a company’s operating capital efficiency, it can be helpful to treat issues with ROIC and capital allocation separately. Additionally, Mauboussin suggests that analysis of invested capital should include only the level of cash that the company requires to run its business.

Goodwill (acquisitions)

It can be helpful to distinguish between and account for both operating returns and acquisition returns. This is more so if company mergers and acquisitions involve payment of large premiums. However, if a company is expected to be less acquisitive going forward (e.g. change in management), it might be appropriate to exclude goodwill from invested capital calculations.

Goodwill (write-offs)

When the value of an asset drops below certain value thresholds, accounting standards may require the business to write off the asset. It might be important to add back asset write-offs to invested capital to better capture the efficiency of capital allocation. In other instances, adding write-offs back might not improve the economic picture (e.g. new management and capital allocation strategy). Some judgement is required.

Restructuring charges

Restructures often include a non-cash asset write offs and a provision for restructuring charges (e.g. equipment relocation, headcount reduction, etc.) to capture the cash outlay. Asset write-offs can be treated in the same way as discussed previously. While restructuring charges can distort ROIC in the short term, provisions generally do not need to be made as accrued restructuring liabilities decline with subsequent cash outlays.

Operating leases

Operating leases are all lease obligations that are not capitalised or captured on the balance sheet. Leases should be reflected in ROIC calculations to capture financing choices, particularly for capital intensive industries. Generally, this involves adjusting NOPAT by reclassifying lease interest payment expenses as a financing cost (instead of operating); and adding the implied principal amount of the lease to assets and debt. Additionally, do keep in mind recent changes to GAAP and IFRS lease standards, which now require companies to classify operating leases as a liability on their balance sheet.

Research and development

For R&D intensive companies, it might be to capitalize and amortize R&D to reflect its long-term expected benefits. We might otherwise understate the earnings and invested capital used in calculating ROIC. Note that free cash flow and intrinsic value remains unaffected by such adjustments. Similarly, we also might make adjustments for companies that underrtake significant marketing in the early stages of its business lifecycle.

Minority interest

We may have to make adjustments to ROIC if a parent company has substantial holdings in the company, or if the company has substantial holdings in another. For the former, tax considerations and size of minority stake is important for valuation purposes. For the latter, it might be helpful to calculate ROIC by excluding the minority stake. We can then add the value of the minority stake value back when determining shareholder value per share.

Share buybacks

Share repurchases do not affect the measure of ROIC if excess cash is excluded from calculations. If the buyback is paid with cash on the balance sheet (i.e. excess cash by definition), then neither NOPAT nor IC will change. Similarly, if the buyback is financed through debt, NOPAT remains unchanged since it is financing neutral. IC also remains unchanged since the increase in debt is offset by the decrease in equity.

Further reading

References